Netbook Sales Could Further Erode Microsoft's Profits

Microsoft has yet to reveal its Windows 7 upselling strategy with netbooks, but Redmond's profit margins already appear to be diminished with Windows XP -- the current option for netbook users wanting to run a Microsoft operating system.

It costs PC makers building netbooks "less than $15 per netbook for Windows XP," even after rebates, according to a Wall Street Journal article published on Monday. The article, which didn't cite a source for the proprietary information, noted that the XP licensing cost is far less than the "$50 to $60" Microsoft gets from a copy of Windows Vista on a new PC.

Netbooks are low-tech, low-cost, miniature laptop-like devices used for e-mail and connecting to the Internet, as well as for running some lightweight applications. They typically lack the hardware requirements to run Vista, for the most part. Currently, netbooks ship with the XP or Linux operating systems installed. However, Microsoft has been suggesting that all editions of its newest operating system, Windows 7 (still in beta), will be capable of running on netbooks.

"Windows 7 will have a smaller footprint, faster boot time, higher security and much stronger networking capabilities with 3G built-in thanks to chips from people like Qualcomm, Ericsson and others," said Robbie Bach, Microsoft's Entertainment and Devices Division president, at CTIA Wireless 2009 in an April 2 transcript. "So you are going to see these machines [netbooks] become full-fledged PCs in a very connected world."

PC Sales on the Decline
By default, netbooks represent a sales growth opportunity for Microsoft's desktop OS business segment. PC sales, in contrast, represent an area of decline. A Gartner report described PC sales in the fourth quarter of 2008 as the lowest since 2002, while netbook sales were seen as providing some growth.

Still, netbook sales have had the effect of cutting into Microsoft's profits. According to Microsoft's second-quarter financial report (ending on Dec. 31, 2008), "client revenue declined 8 percent as a result of PC market weakness and a continued shift to lower-priced netbooks."

Newer preliminary figures from Gartner described a continued downward trend for PC sales in 2009. Last week, the analyst firm reported that 67.2 million PC units were shipped in the first quarter worldwide, representing a 6.5 percent decrease compared with the first quarter of 2008.

Essentially, netbooks are now the only game in town.

"If you look at even some figures that came out today -- not from ourselves, but from others -- there's been a significant decline in the [PC] market over the last two quarters as you might expect," said Paul Jackson, principal analyst at Forrester Research, in a phone interview. "From the OEMs' perspective, netbooks are better than nothing at the moment, and nothing is what a lot of consumers are telling us they are doing instead."

Forrester found that half of people intending to upgrade their PCs were deferring their decisions, given recessionary pressures, Jackson said.

Jackson couldn't vouch for the accuracy of the $15 XP pricing information released by the WSJ . However, even with the discount that OEMs get for Windows licenses, Microsoft's pricing would almost double the bill of materials for netbooks, Jackson said. Netbooks can sell for as low as about $300.

Victory over Linux?
Microsoft has already diminished the threat somewhat from Linux-based netbooks. Microsoft CEO Steve Ballmer said in late February that "Windows has a more than 90 percent attach rate on netbooks." The switch occurred due to some customers' struggles with Linux. According to Jackson, people who purchased a netbook running Linux versions got a discount on the OS of about $100, but they sometimes ran into a poor desktop environment with low functionality and device drivers that didn't work.

Netbooks running XP were "slightly more interesting than a Xandros Linux distribution," he said. Still, some Linux flavors, like Ubuntu, have shown promise.

"If you look at Ubuntu's netbook-optimized Linux OS, it's pretty good now," Jackson said. "It has a rather slick UI and takes advantage of DirectX and graphics acceleration."

Netbook sales may also have a diminishing effect on Vista-based laptop sales. Netbooks sold today using Intel's Atom CPUs now have capabilities that are somewhat similar to a low-end, 12-inch laptop, Jackson explained.

Windows 7 on Netbooks
Windows 7, when released, will have a stripped-down Starter edition that will run at most three separate applications at a time. The product will enable the user to upgrade to more expensive, feature-packed editions of Windows 7 by simply turning on the bits with a licensing key.

The assumption has been that the Starter edition might prove to be too limiting for consumers. However, a report by Ed Bott, who has been testing the Starter edition, found that it meets the needs of a netbook user quite well. For instance, multiple tabs running in a browser will count as just one running application, so users appear to be less constrained than commonly assumed.

Microsoft has yet to describe pricing for Windows 7, so it's still not clear if the Starter edition running on a netbook will boost Microsoft's margins over its current XP pricing. Microsoft specifically extended the sales life of XP Home edition to run on netbooks, with new sales ending on "June 30, 2010, or one year after the general availability of the next version of Windows," according to Microsoft's lifecycle policy.

"Calling it a Starter [edition] is possibly not the best policy," Jackson said. "It's kind of like training wheels. At least rebrand it as 'Windows 7 Netbook edition.'"

Beyond the possibility of selling Windows 7 upgrades on netbooks, Microsoft has also suggested that it might get a revenue boost from selling its future online Office products. Steven Elop, Microsoft's president of Microsoft's Business Division, said in early March that Office 2010 would provide an opportunity for use with netbooks, enabling monetization of SKUs. Elop also estimated at that time that netbooks would account for less than 10 percent of sales.

The Telco Factor
Microsoft may face other pressures on its desktop OS revenues, especially if the designs of netbooks shift in response to telecom companies leveraging netbooks as connection devices. For instance, some mobile operating systems, such as Google's open source Android, might be used to power netbooks. Android will have the advantage of being used in conjunction with power-saving ARM-based devices.

"I think [you'll start to see change] as you start to see Android coming to the fore, or you start to see ARM-based devices reaching market with Qualcomm's [Snapdragon] processor or one of the other ARM licensees, and -- the joker in the pack -- as you start to see telcos engineering devices around netbooks," Jackson said.

He added that the telcos could have a fairly big say about netbooks, which could lead to a division of sorts between "Windows small PCs and those sort of ARM-powered, telco-subsidized, Linux- or Android-running smaller netbooks which specialize in battery power and connectivity rather than being little PCs."

Android can be used for netbooks by design. A spokesperson for Google explained in an e-mail that "the Android smartphone platform was designed from the beginning to scale downward to feature phones and upward to MID [mobile Internet device] and netbook-style devices."

Microsoft's Bach noted that netbook sales have already taken off in association with the mobile phone market. In his CTIA Wireless presentation, Bach said that the top U.K. seller of netbooks is Carphone Warehouse.

"It's a very interesting trend, and a very big shift," Bach said, adding that "by 2012, our estimate is that about a third of these netbook PCs will be sold by mobile operators."

Finally, the very term "netbook" may eventually disappear due to litigation. Psion, a maker of personal digital assistant devices, has sued over copyright infringement on the netbook name. Because of Psion's lawsuit, which has Intel and Dell in its sights, "people call them mini-notes or ultra-mobiles or webtops," Jackson said.